What is Shadow Pricing
Shadow pricing is used to refer to either one of two things: the actual market value of a money market fund share, or, more commonly, the assignment of a dollar value to an abstract commodity that is not ordinarily quantifiable as having a market price, but needs to be assigned a valuation to conduct a cost-benefit analysis. In the latter instance, a shadow price is assigned to goods that are not generally bought and sold as separate assets in a marketplace, such as production costs or intangible assets.
BREAKING DOWN Shadow Pricing
Shadow pricing is frequently guided by certain assumptions about costs or value. It is generally a subjective and inexact, or imprecise, endeavor.
Shadow pricing as it relates to money market funds refers to the practice of accounting the price of securities based on amortized costs rather than on their assigned market value. Money market fund shares are always assigned a nominal net asset value (NAV) of $1, even though the actual NAV is usually slightly more or less than $1. Such funds are required by law to disclose the actual NAV – the shadow share price – to show the fund's performance to investors more accurately.
However, the use of the term "shadow price" in relation to money market funds is the less common usage. It is more frequently applied in the process of cost-benefit analysis in business decision making.
Shadow Pricing in Cost-Benefit Analysis
To make a decision regarding the undertaking of a project or investment, businesses often perform a comparative analysis of the project or investment cost against the projected benefits. In performing a cost-benefit analysis, a business must often account for the costs or benefits of intangible assets that are difficult to assign a dollar value to but that must nonetheless be monetarily quantified for the purpose of performing the analysis.
An example of shadow pricing as applied to a proposed business plan to renovate a company's office facilities might be the assignment of a dollar value to the expected benefits of doing the renovation. While the cost of the renovation can easily be assigned a dollar value, there are elements of the project's expected benefit that must be assigned a shadow price because they are not as easy to quantify. The possible benefits of the project include improved employee morale, lower staff recruiting costs, a lower employee turnover rate and increased productivity. Since it is impossible to assign a precise dollar value to such potential benefits, an estimated shadow price is assigned to set a dollar figure to compare with the cost figure.